Posts Tagged ‘IRA’

In these trying economic times, more and more people who need money are looking to sources such as their retirement accounts. Generally speaking, if you withdraw money from a traditional individual retirement account (IRA), 401(k) or other qualified retirement plan before age 59½, you are subject to a penalty. Early withdrawals carry a 10 percent federal penalty and a 3.3 percent Wisconsin penalty. The money is also considered taxable income

Before taking that hit, consider these options.

Tap your Roth IRA or Roth 401(k). This is one of the easiest ways to get at retirement funds because you can make withdrawals of contributions (but not earnings), without paying penalties or taxes since contributions are made with after-tax money. But be aware that the long-term impact of raiding your Roth can be significant since you won’t have as much money growing tax-free for years.

Take out a 401(k) loan. Most 401(k) plans and several other types of employer-sponsored plans allow investors to borrow up to half of the vested balance in their account, up to $50,000. Terms vary, but most require borrowers to repay the loan within five years. Those who use the money to buy a home may get a longer repayment period. Plus, the 401(k) loan typically requires no credit check, minimal paperwork, and borrowers often get a better interest rate than at a bank.

Use one of the exceptions to penalties. There are a bunch of them.

You can, for example, take regular distributions from an IRA, 401(k) or other retirement account. This is the most commonly used option. You are permitted to make regular withdrawals of equal annual amounts over your remaining life expectancy without paying the penalty. You must take these payments at least once a year for a minimum of five years or until age 59½, whichever is longer.

Other exceptions include:
• Becoming totally and permanently disabled.
• Being in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
• Being required by court order to give the money to your divorced spouse, a child, or a dependent.
• Being separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.

With Congress in a stalemate, it looks like tax uncertainty will be around for awhile. There was a good article in the Wealth and Personal Finance section of the New York Times on February 18. A copy of that article can be found here.

One of the strategies covered in the article, which I have been recommending to my clients, is converting traditional IRAs to Roth IRAs. This results in the recognition of income and the payment of tax. This strategy requires some analysis to make sure it works for you, but later distributions from a Roth IRA are not taxable income and there are no minimum required distributions to worry about in retirement.

The greatest obstacle to this strategy in Wisconsin has been that Wisconsin law differs from federal tax law. Wisconsin law does not permit IRA conversions, which leads to problems like being subject to an excise tax.
The good news is that the Wisconsin legislature has passed a law conforming Wisconsin law to federal law. It is waiting for the governor to sign it. He said that he would. I will let you know as soon as he does.

There are ways to supercharge an IRA conversion. Split your IRA into separate IRAs according to investment type before doing the conversion. That is, create an IRA for your large cap investments, a separate one for mid-caps, and so on. That gives you a right to a “do-over” depending on the performance of the investments.

For example, a taxpayer has two mutual funds in her IRA. One is a large cap fund and the other is an emerging growth fund. She splits the IRA into two IRAs. One holds the large cap mutual fund and the other holds the emerging growth fund. By converting the $100,000 large cap IRA in 2010, she will recognize income of $100,000 and pay tax on that amount (if no other tax planning is done). The same is true of the $50,000 emerging growth IRA. The taxpayer, however, has the right to re-characterize her IRAs by the due date of her tax return including extensions (October 15, 2011). She can change back to a traditional IRA and recognize no income. So if the large cap fund declines in value to $60,000, she can re-characterize and not recognize $100,000 of income. Then she can start all over again and convert her IRA in 2011, but at the lower value of $60,000. None of this affects her emerging growth IRA which doubled in value during the same period and which she wants to keep in a Roth IRA.

Good move. Who would want to re-characterize and then recognize more income in a later conversion?